Individual investors are faced with numerous investment decisions and financial products. It is important for these investors to establish personal financial goals. For many, these goals are long-term, such as supplementing government retirement programs or paying for a child's education. Others may have more immediate goals such as making a down payment on a home or car. Regardless of the goals, many investors choose to invest in mutual funds in order to achieve these goals. Former SEC chairman Aurthur Levitt is quoted as saying “Mutual funds are the primary investment vehicle of choice for most Americans.”
The first mutual fund was offered in the United States during the 1920's. The idea was to provide to investors a company that invests in a diversified portfolio of securities. Individual investors who buy shares of a mutual fund are its owners or shareholders. The money invested by these individuals is used to purchase securities such as stocks or bonds.
The Investment Company Act of 1940 provided the legal framework that allowed for creativity in the development of the industry and guarded against the possibility of abuse. During the five years after the enactment of the Investment Company Act, total assets of all mutual funds tripled. In recent times this growth rate has been even more dramatic. According to the Investment Company Institute Annual Report for 1999, 49.2 million US households or an astonishing 48.2 percent own equities either in mutual funds or individually. The growth in popularity of mutual funds in the United States continues. According to the 2000 Investment Company Institute Annual Report, U.S. based mutual funds account for 6.969 trillion dollars under management. Equity Funds constitute 3.96 trillion dollars of that amount.
Mutual funds can make money in two basic ways: a component security can pay a dividend, or a component security can appreciate in value. Mutual funds lose money when component securities depreciate in value.
Many mutual funds invest primarily in stock. A share of stock represents a unit of ownership of the company which issues that stock. If the company is successful, the stock may increase in value, or the company may pay a dividend to its shareholders, which may be a mutual fund. Investors who buy shares of such a mutual fund become, in essence, part owners of each of the securities in the portfolio. As the value of the securities in the portfolio increase, the value of the investors' investments in the mutual fund increases.
Investors choose to invest in mutual funds over individual stocks for many reasons. These reasons typically include professional management, diversification, liquidity, and convenience. Mutual funds are usually managed by an individual or a team who chooses investments to match the fund's objectives. These managers are often experienced investors who can devote the time required to continually monitor the investments of the fund. The performances of the numerous mutual funds available to investors vary widely. By diversifying investments, the mutual fund can reduce the adverse impact of a single investment. Therefore, mutual funds typically hold a broad variety of securities. Moreover, since the money used to buy the securities is the aggregate investment of all the fund investors, the mutual fund can purchase more securities and offer a more diversified portfolio than most investors could achieve individually. Since mutual fund shares can be sold on any business day, they are liquid investments.
There currently exists a mind boggling over 11,767 mutual funds from which investors may choose. Of these many funds, only 18 performed better than the Dow Jones Industrial Average (DJIA) over a fifteen year period between, Dec. 31, 1985 and Dec. 31, 2000. The DJIA is an index of 30 blue chip stocks or securities. The DJIA is a price weighted index. Editors of Dow Jones and Company decide on the admission and removal of a particular component and on the weighting mechanism to determine the value of the DJIA. The DJIA is often used as an indicator of the overall performance of the stock market. Other common stock indices include the S&P 500 and the NASDAQ Composite Index.
Index funds over time have become a popular investment tool. Index funds are an efficient method of obtaining broad diversity allowing investors to passively embrace the performance of a particular market index. Stock index funds seek to match the returns of a specified stock index, such as the S&P 500, an index of 500 companies in the U.S. An index fund simply seeks to match “the market” by buying representative amounts of each stock in the index, rather than paying a manager to select individual stocks, sectors, or investment strategies. In many cases, index funds outperform professionally managed mutual funds benchmarked to particular indices.
Another popular approach of investing used by many is known as dollar cost averaging. This refers to the practice of investing the same amount of money in the same investment at regular intervals, for example every month, regardless of current market conditions. Because this method is predicated on investing the same amount each time, the investor automatically buys more shares when the price is low, and fewer when the price is high. The benefit of this approach is that, over time, investors may reduce the risk of having bought shares when their price was highest. Proponents of this method warn against “timing the market.” The volatility of stock prices and the many factors that can affect stock prices, make it difficult to predict when a stock price has reached, or will reach, a low point or high point.
Rapidly changing markets and stock price volatility increases the degree of difficulty individual investors face when selecting individual stocks for either purchase or sale in an attempt to manage their personal stock portfolios. Investors choosing to invest in mutual funds are faced with an abundance of funds, the vast majority of which do not approach the aggregate performance of the securities which make up the components of a representative benchmark index, despite being professionally managed.